Many borrowers simply not ready for prime time

In today's mortgage market, "subprime" has become something of a four-letter word, with the popular misconception being that anyone with less than a prime loan is some kind of derelict.

In mortgage parlance, subprime is the term used to describe that group of borrowers who don't measure up to the high and rather rigid standards of conventional lenders. Perhaps their credit histories are pocked with late pays. Or maybe they haven't been on the job long enough to qualify for the lowest rate and best terms.

But just who are these subprime borrowers we keep hearing about? And why are they in so much trouble?

Certainly, some are scofflaws who never intended to meet their mortgage obligations. But for the most part, they are people just like you and me who wanted to get in on the housing gravy train while it was still chugging uphill.

Yes, a certain number shouldn't have been approved for a mortgage at any price. Their financial situations were so faulty that there was no way they could be successful owners.

But a closer look reveals that the group of borrowers branded second-class citizens cuts a wide swath across society. They are our friends and neighbors, perhaps even family members.

"It's difficult to define a subprime borrower," says Jay Brinkmann, vice president of research and economics at the Mortgage Bankers Association in Washington, D.C. "But this much is true: If you make 11 payments during a year but at some point have difficulty coming up with the 12th one, that's what makes you subprime. And if you are living on the edge and miss just one payment, it is very difficult to get caught up."

According to the MBA, moreover, most subprime borrowers are making their house payments on time, just like everybody else. The latest delinquency rate among borrowers categorized as subprime is 22 percent, the trade group reports. That means 78 percent are current.

Yes, the default rate for subprime borrowers is much higher than that of prime borrowers. It's also somewhat higher than it was a few months ago, and it will probably rise. But for now, nearly four out of five subprime borrowers are making their payments every month, a fact that gets overlooked in the horrid details of mortgages gone bad.

That said, let's take a closer look at the bucket of borrowers classified as subprime. To some extent, there is overlap with groups described below. But to paraphrase the great philosopher Pogo, we have met the subprimes and they are us:

Former primes. Perfectly fine, stand-up people often have life events that knock them down financially. Perhaps they lost their jobs, are going through a divorce or are suffering from a catastrophic illness.

Greg Lumsden, president of Full Spectrum Lending in Pasadena, Calif., the subprime lending division of Countrywide Home Loans, calls them "fallen angels."

"It's not their fault," Lumsden says. "When we got into the subprime business in the late 1990s, the majority of borrowers came from prime land. They were prime at one time but somehow got into trouble."

According to Experian, just one missed payment in a year drops a typical credit score from an average 759 to 598, a number that pushes borrowers into a territory where loan rates are 2 or more points higher.

Future primes. People who have messed up are taking higher-rate loans with the promise that if they make their payments on time for one or two years, their rate will be lowered automatically. These loans are known variously as "credit repair" or "credit comeback" mortgages, and they work, says Lumsden. Some 55 percent of subprime borrowers refinancing today are moving to prime status.

Rookies. Many first-time buyers simply lack a large enough down payment or do not have the credit and/or employment histories to qualify for the best rate and terms. But they go ahead, thinking perhaps that they'll refinance in a few years. About a third of all subprime loans issued to people buying homes were made to first-time borrowers.

Second homers. A handful of subprime loans went to people buying vacation (2 percent) or investment (5 percent) properties, according to the MBA.

Either way, it's safe to say that while their credit records may have been good enough to purchase a first home with a prime mortgage, they didn't have enough credit to obtain a prime loan on another home or their credit records were no longer good enough to do so.

Defrauders. It doesn't matter to con artists what rate they are charged; they don't intend to make any payments. Through numerous scams, their goal is to collect huge sums of money from lenders and then head for the hills. So they qualify for whatever loan they can.

True believers. Somewhat akin to rookies, these are buyers who want to ride the wave of home-price appreciation at any cost. They believe the trip will last forever, but as history has shown time and again, the wave eventually curls and crashes. So now there are a bunch of subprime borrowers who owe more than their houses are worth. They simply got in too late.

Ne'er-do-wells. These are the people who never should have been approved, period. They are habitual late payers, or worse -- no payers. Their finances are such a mess that they can never be straightened out. Yet they, too, want a piece of the American Dream. And they often find someone to walk them blindly into what quickly becomes a nightmare.

Victims. Here are the true horror stories. The media are full of reports about uneducated borrowers who have lost their homes thanks to unscrupulous mortgage professionals.

Industry representatives tend to downplay this as only "anecdotal" evidence that does not point to a larger problem. But the truth remains that unprincipled brokers or lenders have hoodwinked too many people into taking loans with inordinately high rates, expensive prepayment penalties or impossible balloon payments.

Should haves. Then there's a whole other group of borrowers who could have qualified for a prime rate had their applications been underwritten more carefully -- or even correctly.

Perhaps they were dealing with loan brokers who pushed them into subprime territory to collect a larger commission. Maybe their lenders didn't want to go the extra mile to qualify them for a lower rate. Or perhaps they fell through the cracks. Whatever, they should have received a prime loan but didn't.

Others. This catch-all category includes borrowers with adequate credit qualifications who have complicated pay structures. According to Jake Domer, senior vice president for subprime lending at Washington Mutual in Seattle, this group includes folks paid on commission or people who use alternative documentation such as bank statements to qualify.

This bucket also catches people who are living together -- a brother and sister, for example, or two extended families.